Welcome to life after the housing boom

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The key to understanding what has been, is and will be going on
in the economy is to appreciate the dominating role of the recent
humungous housing boom.

Until sometime last year, the economy went through a period of
strong and often above-trend growth, the chief cause of which was a
boom in the new and established housing markets.

Investment in new housing and renovations was running at up to 2
percentage points of gross domestic product above its long-term
average.

But consumer spending - which accounts for about 60 per cent of
GDP - was also growing well above trend, hitting average annual
growth of 5.6 per cent in 2003-04.

It seems clear the housing boom was the primary cause of the
outsized growth in consumption. For one thing, when you build a new
house - or just extend or renovate an old one - you're inclined to
go out and fill it with new furniture and appliances.

For another, the nationwide doubling in established house prices
over the six years to March 2004 prompted a "wealth effect"
undoubtedly bigger than we've ever experienced before.

As the value of their homes soared, people felt a lot wealthier
and so let out their belts. They allowed their consumption spending
to increase a lot faster than the growth in their disposable
incomes, so that the household saving ratio fell from 5.6 per cent
in 1996-97 to minus 3.2 per cent in 2003-04.

Whereas the traditional behaviour of home-buyers had been to pay
off their mortgages as soon as they could, thereby continuously
increasing their equity in their homes, many households withdrew
equity by increasing their mortgage and using the funds to support
their lifestyle.

We've had plenty of housing booms in our time, but nothing on
this scale. It had three peculiar causes. First, the delayed effect
of the financial deregulation of the mid-1980s in spreading
innovation and intense competition from commercial lending to home
mortgage lending.

As part of this, we saw the advent of the home-equity loan - the
device that facilitated the wealth effect. It allowed people to
withdraw some of the equity in their home and spend it on
consumption.

The second cause was the belated return to low inflation and the
consequent halving of nominal mortgage interest rates, which
roughly doubled the borrowing power of home owners.

This, in turn, unleashed a long-suppressed desire of many people
to improve the quality of their housing. Unfortunately, when so
many people decided to "trade up" at pretty much the same time, we
got a boom of unprecedented size that managed to double the price
of a largely unchanged stock of houses.

The third cause was the Howard Government's decision to leave
the negative-gearing loophole open while reducing the value of
superannuation concessions to high-income earners and halving the
tax on capital gains.

The result was an orgy of investment in rental properties -
investment far out of line with the demand from renters - which has
left many better-off households over-exposed to a decline in house
and unit prices or a rise in interest rates.

The investment property orgy probably made a significant
contribution to the doubling in house and apartment prices.

Everyone knows that, from 2001, the housing-led boom in
domestic demand was accompanied by a contraction in
external demand as export volumes stopped growing while
import volumes grew in double figures.

What many people don't realise, I suspect, is that the housing
boom effectively crowded out external demand ("net exports"). You
can see this from two perspectives. The first is that, on the one
hand, the housing boom added to consumption and so reduced saving
while, on the other, it added to investment (in the housing stock).
So, by reducing national saving and increasing national investment,
the housing boom caused a widening of the current account
deficit.

(As part of this, the fact that some people consumed the
increase in the value of their housing meant that, to supply the
credit necessary to finance the huge growth in lending, the banks
had to borrow heavily from abroad, thereby adding to the capital
account surplus and net foreign debt.)

The second way to think of it is that, thanks to the economic
growth emanating from the housing boom, the unemployment rate fell
steadily to a 28-year low of 5 per cent.

The Reserve Bank would not have wanted to see the economy
growing any faster than it did. In its management of demand along
the path it took, the Reserve kept the official interest rate
higher than otherwise, which probably kept the exchange rate higher
than otherwise, thereby crowding out net exports.

That covers the housing boom's part in where we've been. Where
we are now is that the economy has been slowing. It's slowing not
because the Reserve jammed on the brakes but because the boom is
petering out.

Home building activity is contracting slowly. House prices have
stopped rising and are now "flat to down", which has ended the
positive wealth effect. Consumer spending is slowing as households,
not feeling as flush, end their spending binge and focus on
repairing their balance sheets - getting on top of their debts and
reducing their dis-saving.

With employment still growing so strongly, it's hard to be sure
just when the economy began slowing or how slow it is now. But for
convenience, let's accept the Government's forecast of year-average
growth of 2 per cent in the financial year just ending and 3 per
cent in the coming financial year.

What happens now? Well, assuming the air keeps escaping from the
housing bubble at such an orderly rate - with home building
declining only modestly and housing prices steady rather than
falling sharply - we could be in for several years of restrained
growth.

If so, that would be one solution to the question that must be
at the forefront of the economic managers' minds: how binding is
the supply constraint? To put it in terms the Reserve would never
use, is an unemployment rate of 5 per cent above or below the
"non-accelerating-inflation" rate of unemployment?

If we're below the NAIRU, it's only a matter of time before
clear signs of excessive wage growth emerge. The Reserve would head
off the threat to inflation by raising interest rates, thus slowing
growth further and getting unemployment drifting up until it was
safely above the NAIRU again.

But if we're still above the NAIRU and thus no signs of
inflation pressure emerge, continued weak growth would cause
unemployment to drift up. This would be dis-inflationary and would
prompt the Reserve to cut interest rates.

With any luck, a fall in interest rates - possibly combined with
falling commodity prices as the world resources boom subsides -
could cause our dollar to fall and improve the international
competitiveness of our export and import-competing industries.

Which brings us to the last part of the puzzle. With domestic
demand likely to be subdued for some time, when is external demand
going to recover and take over some of the running?

With the miners bringing new production capacity on line and
overcoming infrastructure bottlenecks, there's some prospect of
faster growth in export volumes in the coming year. And with weaker
domestic demand, there's some prospect of slightly slower growth in
the volume of imports.

But it's hard to see much of an improvement in net exports - and
thus a return to faster growth - until (for whatever reason,
domestic or external) the dollar falls and makes us more
competitive.